Understanding The Factors That Affect Corporate Bond Prices

Corporate bonds are crucial financial instruments for both business and individual investors. They allow corporates to raise capital from the investors in return for fixed interest payments. They are categorised into secured and unsecured based on the collateral backing they offer to protect an investor in case of a default. Many factors, like the coupon rate, bond yield, the bond’s creditworthiness, time to maturity, etc., govern the bond prices.  

Let us discuss how corporate bonds are priced and the factors determining their price variations.

How Are Bonds Priced?

Investors must understand the functioning of the bonds as they trade differently from equities. While the equities are traded in the secondary market based on their predicted future value, bonds may trade at, below, or above their face value, depending on various market conditions. The interest rate on the bonds is predetermined, but with the change in the bond prices, bond yield changes, which refers to the annual interest compared to the current market price.

Coupon Vs. Yield: What Is The Difference?

Just like the interest rate in fixed deposits, bonds also have a fixed interest rate known as a coupon rate, which is declared on the face value of the bonds and generally remains the same till it matures.

Similar to equity being traded on the secondary market post IPO, bonds post their issue, enter the secondary market and trade according to demand and supply forces, determining their current price. The total return an investor can expect from holding the bond is reflected in its yield.

For example, if you purchase a 10-year bond of INR 10,000 with a coupon rate of 7.5%, the bond will pay you INR 750 every year until it matures after ten years.

The bond yield is not fixed and may differ based on the bond's current price in the secondary market, which is influenced by demand and supply dynamics. For instance, if the bond's current market price is higher than its face value, say INR 12,000, the yield will differ from the coupon rate.

To calculate the yield, you would divide the annual coupon payment (INR 750) by the current market price (INR 12,000) and express it as a percentage. In this case, the yield would be approximately 6.25% [(750/12,000) * 100].

Conversely, if the bond's market price is lower than its face value, say INR 9,000, the yield will be higher than the coupon rate. Similarly, the yield would be approximately 8.83% [(750/9,000) * 100].

How Do Bond Yields Fall And Rise? 

In the secondary market, bond yields depend on demand and supply. Bond yield has an inverse relationship with bond prices. As in the above example, if the interest rates in the secondary market rise above 7.5%, investors will not buy bonds but can invest in new bonds with an interest rate of more than 7.5%.

In this case, the issuer has to lower the bond's price to increase its yield. When lowering the bond's price, the yield increases because you are getting the same coupon payment for a lower price, which increases the bond’s yield. The coupon rate remains the same as it is fixed when the bond is issued.

Factors Influencing Bond Prices

The market value of the bonds is not crucial for the primary investors who wish to hold the bonds till they mature because they aim to receive regular interest payments and the principal at maturity. However, the market value is essential for investors who wish to trade bonds in the secondary market. Let us have a look at the factors influencing bond prices:

1. Interest Rates: The value of the bond and the interest rates have an inverse relationship. Net present value is calculated for a bond using the ongoing market interest rate as the discount rate. The value of the bond plunges when the market interest rate increases and the discount rate on cash flow increases. Contrary to this, when there is a fall in the interest rates of bonds, the value of the bond increases.
2. Time To Maturity: Prices of long-term bonds have more chances to fluctuate depending on interest rates. They cannot be traded once they are closer to their maturity date. Bond valuation declines faster if the interest rate rises for the bonds with longer maturity periods compared to those with short maturity periods. This is also referred to as the bond duration factor.
3. Bond Structure: Bond structure makes the pricing structure of the bonds different. For instance, a floating rate interest bond fluctuates with the change in interest rates compared to a fixed coupon rate bond. Moreover, call and Put options change the bond's price as it determines maturity. A call option allows the issuer to redeem a bond before it matures, while a put option allows the bondholder to demand repayment before maturity. The call options on bonds increase the bond issuer’s flexibility, potentially leading to higher yields.
4. Credit Rating: The bond's credit rating determines the issuer's risk profile. With the change in the credit rating of the bond, their price may also change. A low credit rating decreases the value of the bond, leading to an increase in the yields. At the same time, a higher credit rating improves the value of the bond and reduces its yield.
5. Market Conditions: Bond prices can be affected by broad market conditions. It is common for investors to take out the money from bonds and put it into equity. This happens when the country’s economy grows positively and there is a bull run in the stock market. But in case of recession or stock market correction, investors prefer bonds for safety, which causes their prices to increase.
6. Inflation: Bond prices typically fall when inflation rises because investors seek higher returns to compensate for inflation. When there is a decrease in inflation, bond prices tend to rise.

Conclusion

Investing in bonds allows you to grow your wealth as it brings stability to your portfolio by generating regular interest payments. Understanding the factors affecting bond prices will enable you to make smarter investing decisions. You can explore corporate bonds offering inflation-beating returns with the curated investment opportunities at Grip Invest.

Want to stay at the top of your finances? 

Join the community of 2.5 lakh+ investors and learn more about Grip Invest, the latest financial knick-knacks and shenanigans that take place in the world of investing.

Happy Investing!

Disclaimer - Investments in debt securities are subject to risks. Read all the offer-related documents carefully. The investor is requested to take into consideration all the risk factors before the commencement of trading. This communication is prepared by Grip Broking Private Limited (bearing SEBI Registration No. INZ000312836 and NSE ID 90319) and/or its affiliate/ group company(ies) (together referred to as “Grip Invest”) and the contents of this disclaimer are applicable to this document and any and all written or oral communication(s) made by Grip Invest or its directors, employees, associates, representatives and agents. This communication does not constitute advice relating to investing or otherwise dealing in securities and is not an offer or solicitation for the purchase or sale of any securities. Grip Invest does not guarantee or assure any return on investments and accepts no liability for the consequences of any actions taken based on the information provided. For more details, please visit https://www.gripinvest.in/. 
Registered Address - 106, II F, New Asiatic Building, H Block, Connaught Place, New Delhi 110001.